The simplest form of money and the easiest to understand is commodity money - money that has widely accepted inherent value, such as gold, silver and copper coins of recognised purity and weight. Gold has been widely valued throughout much of history, so in using it in exchange for goods and services such transactions are effectively barter - one good of a certain exchange value is exchanged for another good - gold - of the same exchange value. Precious metals used as money do take time and effort to make available and they have inherent value, so they do represent wealth provided that the exchange value as wealth is represented by their face value as money.
The value of gold has always been high, but has often been in short supply, so silver has also been used, along with fierce arguments about whether gold or silver is better for economies. Note the English pound sterling, which in Anglo Saxon times was one pound weight of sterling silver. You would need a lot more than a pound coin to buy a pound of sterling silver now, that's the effect of inflation! For small values coins made from less valuable metals were used.
Although gold and silver coins had inherent value, that value nevertheless often diverged from their face value. There wasn't normally a problem when the inherent value was less than the face value, but when the inherent value was more than the face value people would melt coins down to sell as bullion (Conway 2014 p58). This shows that even gold and silver only rarely if ever achieved the objective of being true commodity money where the inherent value of coins exactly matched their face value. Issuers of gold and silver coins also had strong incentives to debase the currency - to substitute the precious metal content for base metal, and history is full of examples of this kind of deception (Martin 2014 p87).
The major disadvantage with genuine (non-debased) commodity money is that the money supply is limited to the supply of precious metals, so the frequency of transactions, rather than depending only on people's ability and willingness to trade, depends also on the availability of precious metals, thereby tying two completely unrelated factors together. This is explained in more detail in the next chapter.
Fiat money has value by being declared by a monarch or government to be legal tender but does not claim to have inherent value. It is the normal physical money that we use all the time and refer to as cash. In the UK it consists of Bank of England (hereinafter abbreviated to BoE) notes and coins. In effect fiat money represents an acknowledgement by the state that it owes money to the holder. UK bank notes even state this on the note, though asking for repayment of a £10 note at the BoE will only result in the offer of another £10 note. Interestingly people think that when a BoE note has been withdrawn from circulation it no longer has any value, and if the holder failed to change it for a new note before the cut-off date then it is lost. However that is not true. The cut-off date only relates to its use for payment purposes. The note still represents a contract between the holder and the BoE, in that the BoE has made a legally binding 'promise to pay'. It will honour that promise for all time by exchanging it for a note in current circulation.[70]
Fiat money has practically no inherent value, but unlike commodity money its supply is able to keep pace with trade requirements. A disadvantage is that its value depends on the trustworthiness and political stability of the issuer, and trust has been abused in the past because the issuer is able to spend the money first at no cost to itself other than the minting of coins and printing of notes (a feature of fiat money known as seigniorage), and monarchs and governments have therefore often been tempted to issue too much so as to increase their own wealth entitlement at the expense of the population (Martin 2014 p88).
Commodity and fiat money are relatively easy to understand. Although notes and coins in current use don't have any significant inherent value they are regarded as having the same value as their face value, and provided that everyone accepts that then for all practical purposes that value might as well be inherent.
Credit money is the one that is the most difficult to understand. It is a monetary claim against an individual or organisation that can be exchanged with others for goods and services. All it consists of is a promise to pay, an IOU, an obligation, but an obligation that can be transferred from person to person, and that makes it money. In effect it is a spendable IOU, provided by a person or company that owes the money and it can be passed in payment for something by the holder to someone else who is then owed the money by the original provider. The most common form is bank money, the money contained in bank accounts, where it represents a claim against the bank, and it represents by far the highest proportion of all the money that is used in the economy.[71] Bank money can be used as easily as cash, or more easily in the case of large transactions. It can be exchanged readily for cash, and cash can be exchanged readily for bank money. Because of these characteristics it is largely regarded as a more convenient form of cash, which indeed it is for practical purposes. But it has some very peculiar characteristics that make it very different from cash.
Bank money has no physical substance, consisting only of numbers in banks' computers, and it never leaves those computers. It is created and destroyed by banks as people take out and repay loans.
If you weren't aware of that or you don't believe it, then you are in very good company. Very few people including many politicians and even economists aren't aware of it either, and banks much prefer people not to know about it. If you think this is so ridiculous that you are inclined to throw the book away please read first what the BoE has to say about it.[72]
Banks don't enjoy seigniorage on the money they create because they don't create it to spend, they create it to lend. To see why this is consider my being able to counterfeit money so successfully that no-one can detect it. If I spend the money then I would enjoy seigniorage - I would be able to exchange it for its face value in wealth. But if instead of spending it I lend it, then destroy it when it is repaid, then I would enjoy no seigniorage, but would enjoy the benefit of any interest that is paid. This is what banks do. The borrower is able to exchange its face value for wealth but that isn't seigniorage either, because they have to repay it.
There will be a lot more said about bank money in Part 2.
Just for completeness there are also other forms of credit money. Any IOU or claim for goods or services against any individual or company that can be used as a medium of exchange is also a form of credit money. These usually have a limited range of circulation. The many forms of Local Exchange Trading System (LETS) credits and community currencies are forms of credit money.[73]